Does Time Warner Cable Pass Buffett's Test?

We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, in order to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we take a look at several companies in a single industry to determine their ROIC. Let's take a look at Time Warner Cable (NYS: TWC) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's actually creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / invested capital

The nuances of the formula are explained in further detail here. This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Source: S&P Capital IQ. TTM = trailing 12 months. *Because ELNK did not report an effective tax rate, we used its 40% rate from TTM. **Because NTLS did not report an effective tax rate, we used its 36% rate from 1 year ago.

Time Warner Cable offers the lowest returns on invested capital of the listed companies, but it offers the kind of steady growth in its returns over the past five years that we like to see. United Online and EarthLink lead the pack in their current ROIC, but their returns have both declined dramatically from five years ago, suggesting a waning competitive position. NTELOS has increased its returns slightly from five years ago, but after a spike in returns three years ago, it has seen gradual declines in its ROIC.

In its second quarter, Time Warner reported a 4.4% increase in its sales. This is largely due to increases in subscriptions and average revenue per subscriber. The company has also generated strong cash flows as it continues to reinvest in its business. In the quarter Time Warner Cable bought back $863 million worth of shares and has continued to pay out a regular dividend, which looks attractive at a 3.1% yield.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.

So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. If you'd like to add these companies to your Watchlist, click below: